Last week, Evan Spiegel, CEO of social media company Snap Inc. (SNAP), said that the company’s Q2 outlook had deteriorated, citing a poor economic environment that had reduced advertising growth estimates. Unfortunately, investors may have to wait until Q2 to understand why Snap’s revenue growth declined. I am neutral on SNAP stock.
It’s possibly the case that Apple’s IDFA (identifiers for advertisers) changes last year have had a bigger impact than management expected. The changes make it harder for advertisers to target iPhone users if they opt out of tracking, which would otherwise improve ad performance.
As Snap has only recently broken into consistently positive EBITDA, the comment from Snap’s CEO caused a 40%+ sell-off on the 24th of May. Investors hate profit warnings, particularly when it comes from tech companies that only recently began to generate positive free cash flow. As you can see in the chart below, SNAP stock has not performed well in recent months.
In comparison to Meta Platforms (FB), Snap has a faster-growing Gen Z user base, with a focus on AR rather than VR. Snap is still a strong growth business but is being re-priced due to higher interest rates, lower liquidity, and smaller marketing budgets from customers.
The market is unsure of how to value Snap due to poor visibility, which makes building a reliable forecast challenging. Marketing is always the first department to experience budget cuts during a recession, which is potentially a sign of things to come if the Fed continues on its current trajectory.
Wall Street’s Take
Snap’s average price target from analysts fell following the CEO’s announcement, with the potential for Wall Street revisions to come.
Overall, there is still a Strong Buy consensus rating from analysts based on 23 Buys, five Holds, and one Sell rating assigned in the past three months. The average SNAP price target of $35.15 indicates 143.3% upside potential.
Ad Market Dynamics
Snap is minuscule compared to direct competitors Meta Platforms, Alphabet (GOOG), and TikTok. According to an industry report from Hootsuite, Snap is ranked as the 13th favorite social media app and is the 12th most used social media app (global data). Snapchat has struggled to reach a similar size to its competitors because of its singular-demographic user base, which is mostly Gen Z.
If it wasn’t for the FTC’s Lina Khan claiming Facebook’s acquisition of Instagram was illegal in 2012 and additional DOJ pressure over the years, Meta Platforms would likely make an offer to buy Snap (at the right price, of course). In fact, it was in 2013 when Snap rejected Zuckerberg’s $3 billion bid for the company.
Over the last few years, short videos have proved to be effective in improving platform engagement, which helps increase daily active user numbers. Instagram, Facebook, and Youtube moved quickly to imitate the success of TikTok’s short video product.
Snap was late to the game, with “spotlight” (launched in Nov 2020), a competitor to Instagram reels and Youtube shorts. While management sounds positive regarding the growth of Spotlight, total engagement broken down by Snapchat product is not disclosed. The following note was published in Snap’s Q1 earnings presentation:
“We observed a 350% increase in the number of Spotlight submissions using creative tools or Lenses compared with Q1 2021.”
This appears to be a great result, but ultimately it tells investors very little. While Spotlight engagement is growing, it might only make up a small portion of total platform engagement.
Despite the CEO’s cost-saving plan and reduction in hiring activity, Snap is still investing aggressively in growth, with 500 new employees expected to be hired this year. Furthermore, Snap is pouring CapEx into AR and recently launched Pixy, a $230 selfie drone, which could prove to be a money hole.
Lastly, Snap’s model works well with brand advertising as opposed to search advertising like Google, which targets users based on their searched interests. Because of Snap’s limited user demographics, unfortunately, they’ll never come close to reaching Google or Meta Platform’s ad revenue numbers. Therefore Snap’s total addressable market is smaller, which is reflected in its valuation.
Growth Relative to Valuation
Undoubtedly, Snap is a growth company, still in the early stages of innovating and finding ways to enhance its offering. The problem stems from the fact that investors do not understand the growth potential of Snap’s user base. For example, is the Gen Z demographic going to be interested in a $230 autonomous selfie drone? Is this really feasible, or is it too expensive for the market demographic?
Snap saw daily active user growth accelerate in 2020 and 2021. However, it could be argued that its user growth in those years was directly related to the pandemic. Therefore, a slower growth rate of 10% could be more realistic, similar to 2018 and 2019, going forward. Revenue has grown faster than the user base over the last five years; however, net income has remained in negative territory for the majority of quarters over the last five years.
With a $23.7 billion market cap, Snap does have a reasonable amount of growth still priced in considering sub $1 billion EBITDA in Fiscal Year 2021. While EBITDA is expected to grow to $1.2 billion by 2023, these estimates are questionable considering the economic environment. Nonetheless, if these figures are achieved, this would give Snap a 2023 forward EV/EBITDA of 19.8x.
Since going public in 2017, Snap’s share count has grown by 38% representing roughly 7.6% dilution per year. This puts increasing downward pressure on future EPS figures and share price appreciation as investors get diluted.
Stock-based compensation is a necessary evil in tech, which adds an additional risk if Snap fails to maintain the high growth rates expected by the market. Retaining the best software engineers involves attractive SBC plans, which would lead to poor talent retention if not offered as a benefit.
Conclusion
Snap’s biggest opportunity remains in maximizing the growth/engagement of its younger Gen Z user base. Snap is expected to grow faster than Facebook. However, TikTok has disrupted the growth of social media names, taking in more market share. Snap has suffered in terms of market share due to the popularity of TikTok, leaving investors to question Snap’s growth estimates.
I personally don’t believe IDFA changes made by Apple last year will be detrimental to the ad industry, but they certainly won’t aid growth. A deeper explanation is needed in Q2 to understand how important IDFA changes have been one year since Apple implemented the ad privacy changes or if the slowdown is solely macro-driven.
Snap was priced for perfection in 2021, but when growth slows, there’s nothing to support the valuation from collapsing. Until there’s a stable outlook, I would argue Snap is still a risky investment but worth a Hold rating based on the current valuation.
With poor visibility, buying into Snap would require a fair amount of speculation regarding its Q2/Q3 performance. Therefore, I believe a hold rating is fair.
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